For good measure there is another company on my radar that fits the bill, but where investors have yet to cotton on to the magnitude of the undervaluation. Aim-traded Constellation Healthcare Technologies (CHT:178p) is a provider of outsourced medical billing services to US physicians. Its main service is billing for, and then collecting, the money due to physicians, largely from insurance companies. This market is estimated to be worth $37bn (£29.8bn) a year, the vast majority of which is accounted for by office-based physicians, with the remainder being hospital-based physicians. The hospital billings market is worth a further $44bn each year.
The market is fragmented, with around 2,000 small providers servicing it and less than half of billings being outsourced. US medical billing companies have to deal with a complex web of insurance companies and patients, multiple plans, medical codes, and constantly changing rules. As a result this creates a significant barrier to entry to non-medical billings providers, as well as supporting the fees charged by the service providers. Also, clients are becoming increasingly data-hungry, and have a greater focus on improving collection rates, which is putting pressure on smaller, less well invested service providers.
These market characteristics are driving consolidation in the industry and leading to a focus on technology and cost reduction by off-shoring the more process-driven and data entry jobs to lower cost regions. Although Constellation is only a £163m market cap company, it is aiming to become a major provider of US medical billing services by pursuing a bolt-on acquisition strategy in order to add doctors to its platform quickly. And given the fragmented nature of the market, the company is able to acquire smaller rivals on historic enterprise valuations of between five to nine times cash profits, and then eke out cost savings by moving between half and 80 per cent of the acquisition targets' jobs from the US to its captive business processing outsourcing operations in India. The cost savings are huge as this typically reduces an individual's annual salary costs from $45,000 to $10,000.
The success of this strategy was evident in last month's half-year results when the company increased cash profit margins from 29.9 per cent to 37 per cent on revenues up 78 per cent to $57m, driven partly by the contribution from acquisitions but also including like-for-like revenue growth of 22 per cent in the core medical billings business. Constellation continues to win new clients and added 15 in the six-month period, highlighting that it is more than just an acquirer of smaller businesses and is not reliant on M&A for its growth.
That said, having raised £9.6m at 135p a share at the time of its Aim flotation in December 2014, the company has successfully completed two further placings, raising a total of £12.9m at 140p in May 2015 and £30m at 160p a share in February, the proceeds of which helped fund four acquisitions in its first 15 months as a listed entity: Physicians Practice Plus (PPP), NorthStar First Health, Phoenix Health and MDRX Medical Billing. The $30m (£24.2m) acquisition of MDRX completed in February and added 3,500 physicians to the Constellation platform, meaning that there are now 10,000 doctors using it for their billing requirements. It's very profitable, too.
Acquisitive growth paying off
Buoyed by cost savings, contributions from acquisitions and robust organic growth, Constellation's latest half-year cash profit surged by more than half to $21m on revenue of $57m. Cash flow from operations rocketed, too, up 160 per cent to $10.9m - a performance that put the company in a net cash position of $9.6m at the end of June 2016. I would flag up that the board has subsequently paid off all its debt facilities after the half-year end without tapping the proceeds from a £30m placing earlier this year, which funded the $30m MDRX acquisition. These funds will be deployed on fresh acquisitions.
And the board under the leadership of chief executive and founder Paul Parmar, who owns 44 per cent of the 91.4m shares in issue, has wasted no time in using the cash pile to make the company's fifth acquisition since flotation. Constellation has just acquired VEGA Medical Professionals for a maximum consideration of $24m, of which $14.4m of the initial $18m consideration was funded by cash on its balance sheet and a $12m vendor loan from an entity represented by the chief executive of VEGA. This three-year loan carries an interest rate of 7.5 per cent and can be converted into Constellation's shares upon the election of either the board of the company, or the vendor, but subject to conditions that protect Constellation's shareholders' interests. The balance of the $3.6m initial consideration was settled in shares priced at 140p each.
VEGA provides outsourced healthcare practice management and consulting services including outsourced billing, collections, operations and financial management to both independent and hospital-based physician groups. The acquisition will provide Constellation with expertise in hospital-based billing through its offices located in New York, New Jersey, Texas, and Pennsylvania. In the 12 months to 31 July 2016, VEGA generated underlying cash profit of $800,000 on revenue of $15.6m and had net assets of $2m. Cash profit margins of 5 per cent are massively below Constellation's margin of 37 per cent due to VEGA's high US cost base, and guidance suggests savings between the two businesses will result in at least $7m of additional cash profit on a pro-forma basis being achieved in the first 24 months under Constellation's ownership. This implies a cash profit margin target of 50 per cent - in line with those being targeted for PPP and Northstar - and an enterprise valuation to cash profit multiple of three times likely 2018 cash profit for VEGA. The fact that Constellation already generates cash profit margins of 37 per cent highlights the potential to lift VEGA's margins significantly just by outsourcing some of its functions to India.
Impact on forecasts
House broker finnCap modestly upgraded its forecasts for Constellation at the time of the half-year results in early September, and has done the same again to take into account the impact of the VEGA acquisition. Analyst Guy Hewett now expects the company to report full-year revenue of $132.6m, up from $76.7m last year, to increase pre-tax profit from $20m to $31.6m based on cash profit rising by 75 per cent to $42.4m, and deliver 10 per cent growth in EPS to 22¢ (16.4p). Please note that EPS growth will lag behind profit growth this year due to the effect of the share placings, but as savings are seen from the MDRX and VEGA acquisitions next year, then Mr Hewett believes that Constellation can increase cash profits by $10.2m to $52.6m on a $17.7m rise in revenue to $150.3m, and deliver pre-tax profit of $41m and EPS of 26.9¢ (21.7p).
On that basis, the shares are currently being rated on only 11 times earnings estimates for 2016, falling to just eight times in 2017. And because the company still has a cash-rich balance sheet after the VEGA acquisition - finnCap estimates net funds of $2.6m at the end of 2016, implying cash balances of $14.6m offset by the $12m vendor loan - then effectively its enterprise value of £160m equates to only 4.7 times this year's cash profit estimates, and only 3.8 times 2017 forecasts. That's a very low rating for a business that has a clear strategy of successfully extracting cost savings from acquisitions, has a cash-rich balance sheet, and is generating robust operating cash flows that are being recycled into further acquisitions.
I would also point out the recurring nature of the revenue streams. The company's core medical billing services business typically enters into contracts that have two- to five-year terms that auto-renew for additional one-year periods, thus providing visibility of future revenue. This segment accounted for two-thirds of Constellation's revenue last year. In addition, its practice management division provides business, administrative and practice management services to physicians under a 40-year management agreement and has generated stable and growing revenue historically.
The point is that there are not too many businesses that have the potential to lift EPS by 20 per cent in the coming 12 months and which can be acquired on a single digit earnings multiple. Moreover, as I noted at the start of this column, investors have yet to fully recognise the positive translation effect on these earnings from the sharp devaluation of sterling. Indeed, at the start of 2016 the shares were trading around the current price and on 12 times this year's likely earnings and 11 times 2017 forecasts when the exchange rate was £1=$1.47. Since then EPS estimates for 2017 have been upgraded by 10 per cent and sterling has declined by 16 per cent against the greenback, the net effect of which is to lift sterling EPS estimates up by more than 30 per cent to 21.7p for 2017 and reduce the forward PE ratio from 11 to eight. Given the operational progress being made, this multiple contraction is anomalous.
Risks
Of course, any business carries risks and the quality of management is critical in executing the costs savings. Bearing this in mind, non-executive director Sir Rodney Aldridge was the founder of Capita (CPI) in 1984 until his retirement in 2006, during which time the support services group became a market leader in the provision of support and professional services to the government and private sector in the UK.
Mr Parmar has a track record in healthcare businesses and technologies. In 2008, a group he represented bought a controlling interest in a medical billing company and subsequently sold the business to NextGen. He also built a private aviation business that was sold to Delta Airlines in 2010. Constellation's finance director Sam Zaharis has held roles at Ernst & Young, and Kroll Inc, and has previously worked with Mr Parmar. The management team are experienced and also have skin in the game, so are financially invested in the success of the acquisition strategy.
Another risk is that the management team may not be able to identify suitable acquisition targets or be able to finance them, which would limit their ability to pursue their business strategy. There is no guarantee, either, that acquisitions will perform as expected, can be properly integrated or will contribute the forecast savings, revenue or profit. Moreover, the company may face increased competition for acquisition opportunities or could find that vendors may not be prepared to accept its shares in part consideration, thus forcing the board to use its cash on hand, borrow or abandon the acquisition altogether. That said, Constellation has successfully made five acquisitions since its flotation, and raised fresh capital from share placings at increasing price levels, a bull point for vendors when deciding whether or not to accept its shares in part consideration.
Target price
So, having weighed up the risks, and the current valuation, I feel Constellation's shares are being too lowly rated at the current level. In fact, I believe that a target price of 250p is not unreasonable, implying a forward PE ratio of 11.5 for 2017, and an enterprise value to cash profit multiple of 5.3 times.
Interestingly, a share price move above the all-time high of 190p dating back to May 2015 would be a very bullish sign, and one that is likely once investors cotton onto the value on offer. Offering 40 per cent upside to my target price, I rate Constellation's shares a strong buy on a bid-offer spread of 173p to 178p.
